September 27

Two major developments, the transformation of Goldman Sachs and Morgan Stanley into bank holding companies and the heated debate over the US$700 billion ($1 trillion) US Government bailout, demonstrate that the international credit crisis is far from over.

The Goldman Sachs/Morgan Stanley developments signal that credit conditions will continue to tighten and the US$700 billion debate makes it clear that financial institutions will be subject to stricter regulation in the years ahead.

In other words the free flowing credit and "market discipline is the best form of regulation" era is over.

To explain this week's developments we need to look at the accompanying inverted pyramid of global liquidity, which first appeared in this column after the Bear Stearns collapse in March.

In simple terms international liquidity comprises four basic ingredients; power money (notes and coins), broad money (cheque accounts, credit cards etc), securitised debt (mortgages and other packaged products) and derivatives (futures, options, swaps etc).

The power and broad money sections are mainly contained within the commercial bank sector, which is highly regulated, whereas securitised debt and derivatives are predominantly the creation of investment banks, which are almost totally unregulated.

Forty years ago there were almost no investment banks, securitised debt or derivatives. The huge increase in global liquidity and credit since the early 1980s has been almost exclusively driven by investment banks through the creation of securitised debt and derivatives, which now represent nearly 90 per cent of total liquidity.

At the beginning of the year there were five major US investment banks - Goldman Sachs, with assets of US$1061 billion (or US$1.06 trillion), Morgan Stanley US$1045 billion, Merrill Lynch US$1020 billion, Lehman Brothers US$689 billion and Bear Stearns US$424 billion.

Bear Stearns and Lehman Brothers have disappeared and Merrill Lynch is being taken over by Bank of America. These companies created a huge amount of toxic securitised debt and derivatives that have plunged in value.

The conversion of the two remaining investment banks, Goldman Sachs and Morgan Stanley, into bank holding companies is significant for a number of reasons:
* As commercial banks they will be subject to regulation whereas they were almost totally unregulated as investment banks
* Their lending capabilities will be severely restricted because commercial banks have strict capital adequacy requirements. Morgan Stanley's debt to equity ratio is 30:1 and Goldman Sachs 22:1 whereas banks are generally restricted to no more than 15:1.

Morgan Stanley and Goldman Sachs are willing to move from an unregulated to a regulated regime because investment banks have to value all securities on a mark-to-market (market price) basis whereas commercial banks have fewer requirements to do so. This means that the two financial giants can report a stronger balance sheet because they will no longer have to mark down all their securities to market values.

The flip side of this is that they will have to raise more capital to maintain their current level of lending because of stricter capital requirements as bank holding companies. Another problem with the US financial system was the repeal of the Glass-Steagall Act in 1999.

This act was introduced in 1933 to separate investment banking and commercial banking activities. This is because the commercial banks took too much risk with depositors' money in the 1920s by underwriting speculative sharemarket offerings.

Since the act was repealed nearly a decade ago - after sustained lobbying by the big financial institutions - commercial banks have been more aggressive in the traditional investment banking area, particularly securitised debt and derivatives. This has significantly weakened the commercial banking sector.

It is no exaggeration to state that last week our inverted pyramid of global liquidity looked more like one of New York's twin towers on 9/11 with a number of planes heading straight for the two upper trapeziums. If they had hit it would have caused massive destruction to the whole financial structure including the commercial banks operating in broad and power money sections at the bottom.

The US$700 billion bailout is an attempt to save the financial system from imploding, albeit it is now widely recognised that the structure, with the massive amount of toxic securitised debt and derivatives at the top, is structurally unsound.

There was clear evidence of these venomous products in New Zealand this week when Credit Sails, which is a securitised debt instrument sold to the public by Forsyth Barr, announced that it would not pay its quarterly dividend and Standard & Poor's downgraded its rating. Credit Sails' net asset value is only 41c for every $1 subscribed.

The American public is opposed to the bailout because it believes that those responsible for the unsound structure have the most to gain.

A similar situation occurred in New Zealand in the early 1990s when the Bank of New Zealand nearly went under. There was strong public opposition to the Government's purchase of the bank's bad loans because Sir Michael Fay and David Richwhite, who were held responsible for the problems, were perceived to be the main beneficiaries of the Crown's intervention.

But the correct decision was made, the bank was saved and the Government got all of its money back and more.

The only downside to the BNZ bailout was that Fay and Richwhite lived to fight another day and later applied their particular brand of destructive capitalism at Tranz Rail.

The US Government bailout will not solve the finance sector's fundamental problems, namely the excessive use of poor quality securitised debt and high risk derivatives to create credit, but it will give the industry more time to resolve its problems.

Under the bailout the two upper trapeziums in the accompanying graph will deflate in a more orderly fashion. This reduction in liquidity and credit is already under way following the demise of the five largest US investment banks. This deleveraging will continue to have a negative impact on asset prices.

But the bailout won't solve another big problem on Wall St, namely the pernicious culture of financial recklessness, greed and obscene levels of executive compensation. These excesses will encourage legislators throughout the world to introduce a raft of new rules and regulations that will have a huge impact on all industry participants, the vast majority of whom have not participated in this culture of greed.

The bailout also has potential costs for US taxpayers.

The last major US bailout, which was in response to the Savings and Loan Crisis in the late 1980s, cost US taxpayers US$124 billion compared with an earlier estimate of US$50 billion. This rescue programme was a big contributor to higher Federal budget deficits and interest rates in the early 1990s.

The Savings and Loan Crisis, the latest investment banking meltdown in the US and the finance company fiasco in this country clearly demonstrate that the "market discipline is the best form of regulation" philosophy doesn't work.

More regulation is needed but legislators must be careful that they don't overreact and introduce a raft of new regulations that restricts the flexibility of financial organisations. This would probably accelerate the contraction in global liquidity and credit.

 Source: Bank of International Settlement & Independent Strategy